To: Management Team of Xantrex Technologies, Inc.
From: Firm of Geoghegan, Gilpin-Jackson, Lee, McLeod & Renke
Subject: Analysis of Xantrex Technology, Inc. – Options and Recommendations
Per the request of management from Xantrex Technologies, Inc. (‘Xantrex’), the firm of Geoghegan, Gilpin-Jackson, Lee, McLeod & Renke (‘we’, ‘us’ or ‘our’) has reviewed the information provided and performed relevant analyses in the context of specific questions posed by Xantrex management. Our recommendations are provided herein.
1. What are (or should be) the needs and objectives of the owners of Xantrex at this juncture? What are the risks and opportunities available from additional investment in Xantrex at this time from the perspectives of Xantrex and the investors?
Refer to the following needs/ objectives and opportunities listed in order of priority:
a) Maintain strategic control of the organization
b) Raise capital to fund the following:
- Pay back of the FBDB loan (present value, PV, of $487,604 if paid off now rather than a PV of $611,146 if paid off on a deferred basis (per Appendix A)
- Expansion of Test & Measurement (T&M) markets locally and abroad
§ Completion of 3kW T&M product research with late 1996 launch
§ Expansion into EU via products with Power Factor Correction
§ Recruitment of US Sales Manager, more Tier 1 sales reps
§ Expansion into Japan via brand label alliance with Japanese firm - Expansion into telecom industry of emerging markets
§ Development of DC power products able to be localized
§ Recruitment of a telecom sales and marketing manager
§ Country-by-country sales negotiations - Aid ongoing management recruitment into HR, Finance, Sales and marketing
c) Improve cash flow—increase sales; decrease A/R and debt servicing
- Increase line of credit from $0.3M to $1M
- Reduce or eliminate existing loan covenants
- Decrease impact of largest customer’s (Sorensen) slower payments
d) Have good relations with investment group that can add greater value (i.e. expertise)
e) Exit through IPO or selling to another company
Risks to be considered include:
Increased competition in T&M markets
Penetration of foreign markets in a new industry with a new product line
- Long sales cycle; long production runs; thin sales margins; limited regional knowledge; and having little reputational capital in the field
· A/R turnover reducing and negative impacts on cash flow, e.g. Sorensen’s payments
· Recruitment of required personnel and development of more robust sales channels - Inability to get $400K management salary cap lifted (per bank conditions)
2. How much capital should be raised? How much equity should be given up in exchange for the investment?
Assuming a 35% discount rate and employing a market multiple method, the company would be valued between $4M and $20M depending on which revenue forecast is used to value the company (i.e. worst, most likely, current or best) and the EBIT multiplier. We are recommending that the Xantrex begin negotiations by valuing the company based on the best case scenario or a value of $19.829M. They should not accept a valuation below the most likely case of $10.373M.
Xantrex should raise the full amount of $3 Million. Their current balance sheet calls for $2.111M in “required funding” for 1996 and 1997 but that is based on the “best case”. So they would be wise to garner a bit of extra capital as a cushion. For $3M, they will need to give up between 13% and 22% of the company depending on how the company is valued during negotiations.
3. Would you recommend that Management proceed with the contemplated BDC deal? Explain.
We recommend that the BDC deal be pursued as...
- Xantrex has good history with BDC and the relationship would be a good fit,
- VCs can invest the required funds,
- VCs open to deferring cash flow returns;
- VCs have relevant board expertise that can be leveraged and
- Xantrex founders will give up some control of the company for a reduction in debt and access to growth funds.
The only caution is that the investors will require a 25% - 35% annual return (or a 3.1 to 4.5 times return on the money invested). This will require Xantrex to be valued between $59M and $102M within 5 years (assumed exit period for investors).
4. What are the significant criteria and constraints employed by the investors?
- Venture capital to be raised with co-investor;
- Requirement for high liquidity with a current ratio of 1:1, capped inventory and A/R under 61 days;
- WOF cannot provide debt financing;
- Management compensation capped at $400k;
- Vesting restrictions, strategic control and active participation on the company’s board;
- Expected target rate of return of 20% - 35%;
- Increased focus on equity rather than debt
- Shareholders agreement and term sheet required;
- Aggregated investment maxes out at $7M 1st round and up to $10M in total by subsequent rounds
5. Structure an ‘optimal’ deal that would meet investor criteria and Xantrex’s objectives and requirements. Summarize the major terms and any key clauses Xantrex should seek to include in a Shareholder’s Agreement.
Following are the significant terms that Xantrex should seek to include:
- $3 Million VC ($1.5 Million each from BDC and WOF) for 13% of the company based on the “best case” valuation and 25% return to venture capitalists. During negotiations, Xantrex should not fall below the “most likely case” valuation of $10.373M and 25% return to venture capitalists.
- Convertible preferred stock for BDC/WOF with 1:1 conversion and voting rights
- Xantrex will not pay out dividends so as to retain capital to grow the firm.
- 1X liquidation preference for VCs; upon liquidation or material change of control, excluding subsequent financings (original investment + accrued dividends only)
- Board of Directors = 5 people (1 BDC, 1 WOF and 3 Xantrex); expect pushback for inclusion of at least one external party (1 BDC, 1 WOF, 1 external industry expert and 2 Xantrex)
- Compensation Committee with equal membership between Xantrex and VC and including 1 outside member to be jointly agreed upon
- Broad based weighted average adjustment mechanism for anti-dilution, no ratchet
- Founder vesting options at 25% linearly over 3 years with credit for pre-investment time worked and acceleration where control changes or in termination without cause
- Standard First Right of Refusal - Pro rata right based on fully diluted percentage of investor ownership, terminates at close of IPO
Appendices
A. FBDB Loan Repayment Options
B. Company Valuation
I like how you organize your recommendations into point form. It is very easy to read and I am sure executives will be happy to see that.
ReplyDeleteI also agree to your recommendations especially the part on the optimal deal structure which is very inline with the needs and objectives of Xantrex. However, I would recommend to identify more risk in question one. Namely, the risk of getting VC investment vs debt financing. Also, a 35% discount rate in your calculation seems to be a little high to me, have you considered a lower discount rate?
For the 1st question, shouldn't there be some consideration for Xantrex's goal of expanding beyond the N.American market. Their global aspirations should be taken into account when considering their financing needs as well as the potential risks.
ReplyDeleteIn terms of beginning the negotiations assuming the best case revenue forecasts... it may be problematic as BDC is already well versed in Xantrex's previous performance. So while BDC would already be willing to accept terms based on the likely revenue projections, the optimistic forecast may just serve to extend the negotiations further to no justifiable end.
I read through all of the posts and I noticed a range of multipliers, discount rates and valuation methods. What has become evident is that there is probably no single right valuation for a company. It is the final deal that actually determines the valuation. We see this when companies like Twitter get funding and then see headlines stating how much these companies are worth. What is worse is these headlines can themselves be misleading because of how the media can incorrectly interpret the numbers involved. Check out this podcast that Chris sent me that reveals the fallacy of relying solely on these kinds of headlines - http://37signals.com/podcast/#episode2.
ReplyDeleteSo the value of the company can actually shift in real time as the negotiations proceed. And thus, the final value of the company may actually be correlated to the founders' ability to negotiate a favorable deal. So, in order to best advise the founders of Xantrex, our group felt that boundaries needed to be created that allow them to confidently enter their negotiations with the funders and not get taken advantage of.
Hello firm of Geoghegen, Gilpin-Jackson, Lee, McLeod & Renke :),
ReplyDeleteGood analysis guys, and as Eric has pointed out, the point form layout is well organized and would be easy to follow for management team when deciding on the future deal for Xantrex.
In addition to your great analysis, I would consider going into a bit more in debt analysis on the negotiating options especially intangibles that could add value to your recommendations to Xantrex. This in my opinion would help the owners reach the optimal deal with VCs depending on their particular needs.
So here are a few points:
1) I noticed that your PV value of FBDB loan to be repaid is some $50,000 less (yours is $487,604, and ours around 540,254)due to exclusion of the 13% interest on the loan. In our estimates for the FBDB loan repayment we accounted this 13% interest in our calculations, hence the higher amount to be repaid.
2) I agree with Eric, that 35% discount rate might be too high, and would consider using lower or around 20%. Also, I was not clear from your answer, but I assume that for your recommendation on raising full $3 Million refers to raising all equity. Here, I would not be so quick in recommending the full amount since that would mean diluting owners’ share of the company. The way we thought about this was that they should not go for the maximum amount of equity (or the $3 Million) from the VCs. Instead we realized additional funding if needed could be used from the loan, which as a result of raising equity money would increase from $300,000 to $1 Million. So this was in a sense our hybrid response to asking for less equity form VCs but having the debt option if needed from the bank loan, hence giving them more financial flexibility while retaining more control.
3) Also, on the BDC deal, I think it would have helped if you added more options to the owners, particularly on the intangibles of the deal. For example, I think it would be also important who the second VC partner is in addition to BDC for at least two reasons: first, the relationship and how much would the company deal with the chosen representative of the second VC, and second, will the two VCs provide the Xantrex owners with the expertise and contacts that they need in the electronics industry and marketing. In addition, it seems that you settled on the WOF as the second VC, and did not consider recommending discussing with BDC the second VC partner who would be more suitable for what Xantrex needs in case WOF is not the best or the good fit.
4) In regards to the Board of Directors, I agree with you there. In our group, I was proposing that we should try to recommend that two seats go to VCs and three to Xantrex, or at least that Xantrex picks the fifth person and VCs approves, as I do not think that VCs would agree with 3 Xantrex owners on the Board of Directors. I think in the end within our group we actually settled on VCs picking the fifth person and Xantrex approving which gives even less control to Xantrex owners. But I would still try to negotiate for 2VCs, 2Xantres and fifth picked by Xantrex, and approved by VCs.
Overall, good recommendations team Geoghegen, Gilpin-Jackson, Lee, McLeod & Renke.
Thanks,
Sanja
Some insightful comments. Thanks for that.
ReplyDeleteTwice, though, there has been question about the 35% discount we applied in the valuation of Xantrex as well as our use of 100% equity funding for a full three million dollars. Obviously we felt all were justified and so I would like to outline the reasoning behind that and why, in my opinion, using a 20% discount rate or funding less would be inappropriate.
• Xantrex itself has only been profitable for two years and yes, while the future projections do look optimistic, they hinge on some key assumptions for their main Test & Measurement business
o Ability to successfully complete their 3kW T&M product research and delivery in late 1996: while they have been successful in the past per their relationship with Sorensen, the obvious addition of functionality to remain competitive introduces variables that inject uncertainty. Success on this front is not “given.”
• Expansion plans in the international telecommunications for emerging markets. Xantrex is venturing into uncharted territory with these plans.
o Foremost is not having any experience with the telecommunications industry.
o Coupled with little experience in dealing with emerging markets
o And the requirement for end-stage product tailoring that will undoubtedly need to be performed in the field.
o Thin margins means not additional money to go with a distributor intermediary
- No customer-facing intermediary means understanding of the local markets will become even more challenging.
- Thin margins means volume sales and economies of scope and scale will play a larger role; there is no indication that Xantrex can approach let alone achieve the minimum efficient scale required
o Long sales cycle with few large-volume purchasers
- Generating business will take longer and Xantrex will be in line with others to pitch their wares; the competitive nature of this business could push margins even thinner
o Regulatory requirements have to be met on a country-by-country basis with little-to-no in-house experience regarding the countries of emerging markets.
• Covenants currently in place in their relationship with the banks are too restrictive and there is no guarantee they will be adjusted to the point of not hindering Xantrex’s expansion plans.
o Limits on combined management salaries
- Xantrex’s expansion plans are highly dependent upon getting the right people in with highly valuable expertise; any hindrance poses another source of risk
o Limits on capital expenditures
- The planned expansion will be capital heavy in nature
For the above reasons, we feel the 35% discount rate is justified. Some groups stuck with the 20% rate yet that rate is reserved for repayment of a loan based on sales in their mature industry and markets; the risks associated with the expansion plans of Xantrex preclude using a 20% discount rate.
There was also question about going for the full three million dollars in equity financing. The bottom line reason was to build a cushion in funds to help tackle contingencies as they arise in their execution of the DC power supply expansion into emerging markets. The risks just outlined provide insight why such a cushion is justified. In addition, reserving capacity for debt provides another avenue of funding should significant issues arise without having to go back to the markets for, heaven forbid, a down-round financing due to negative press from delays incurred. We could have done a better job of providing our reasoning.
I like how the response is organized. Very concise and clear. There are three comments I would like to make:
ReplyDelete1) I would believe the group assumed pay out the loan is one of Xantrex's goal without comparing the VC financing benefits with Debt financing.
2) I also wouldn't agree 1:1 current ratio is a liquidity requirement as considered high. As far as I know, many bank requires a current ratio closer to 2.
3) I am not sure if the statement "dividend will not be pay out..." should be part of the VC deal. I think this is more of a year to year board decision.
Other than that I like the company valuation as it looks at worse, most likely and best case so Xantrex would be clear on the range that is acceptable.
Cheers,
T.